Affirming the Case for Quality (GMO White Paper); Share Repurchases

Quality Companies are often under appreciated by investors

I hope my wretched scribbling will help your investing journey. We want to learn from the lessons all around us. Study failure so as not to pay a high tuition for knowledge and study success so as to develop your own investment method.  Yes, it is fun to point out the disasters like Sunpeak Ventures (SNPK)—nothing but a “pump and dump”—yet focusing on great companies is more valuable, yet less popular than you might think. Your time is best spent understanding and investing in great companies—either hidden champions that are emerging or dominate hidden niches or great franchises with dominant moats.  This is why I try to write often about competitive advantage, franchises, and quality businesses.

Here is a GMO White Paper (June 2012) that affirms the case for quality. Companies with high and stable profits (KO, PEP, EXPD, M, and GOOG) tend to have lower bankruptcy risk, lower leverage and generally higher returns compared to risk of loss. Please read carefully: GMO_WP_-_2012_06_-_Profits_for_the_Long_Run_-_Affirming_Quality

Ben Graham argued that real risk was “the danger of a loss of quality and earning power through economic changes or deterioration in management.”

The returns earned by stock investors are entirely a function of the underlying corporate profits of the stocks held in a portfolio.  Note the focus that Buffett has placed on knowing where a business will be in five to ten years—a chewing gum company versus a high tech start-up). As he says, “We favor businesses and industries unlikely to experience major change…operations that….are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek.”

Oligopolies tend not to revert—note the persistence of corporate profitability of companies that operate within corporate barriers.

Look at the stability of companies like Tootsie Roll and WD-40. Tootsie Roll (Tootsie Roll_VL) has slowly declining returns on capital but it is shrinking its capital structure. Note the low price variability. Everyone knows about WD-40 (WDFC) (lubricant oil) and Tootsie Roll (candy)—the products will not disappear in the customers’ minds nor become obsolete.

Note on page 4 of the GMO White Paper: While it has become conventional wisdom that the market misprices price-based risk factors like low beta outperforms high beta, we find that it also misprices fundamental risk. . Companies that report negative net income underperform the market by a whopping 8% per annum. The market overpays for risk at the corporate level in much the same way that it overvalues the risk of high beta stocks. Conversely investors had historically underpaid for the low risk attributes of high quality companies.  To us (GMO), investing in Quality companies simply exploits the long-term opportunity offered by the predictability of profits in conjunction with the market’s lack of interest in the anomaly. Their predictability higher profits are not quite high enough to command the attention of a market in thrall to the possibility of the next big jackpot. 

Lesson: focus on quality companies to find better returns for lower risk.

Radio Show on Quality Stocks

For beginners and (those who are willing to sit through or skip the commercials), there are discussions about high clean-surplus ROE companies here:

More on corporate buybacks

Assessing Buybacks from all Angles_Mauboussin


Tomorow I will post the prize to all those who lent their wisdom to:

7 responses to “Affirming the Case for Quality (GMO White Paper); Share Repurchases

  1. My personal issue with buybacks and/or betting on things with lots of change:

    As a former business owner, I saw every year that I reinvested profits as a “continued bet.” Until the day the company handed cash back to the shareholders, I wouldn’t know how I did on an absolute basis. (Ignoring stock price movements)

    Let’s think for a moment – you have an insurer who generates 10% profit on revenue every year, and assume that there’s nothing wrong going on like activities of fraud/deceit. The correctly determine that they produce more value by not issuing dividends and so they continually reinvest the money successfully. Because they always produce 10% profits, they don’t have a tough time estimating an intrinsic value. Thus, they are also buying back stock at very opportunistic times (think of May 2009, etc.). Ultimately, they’ve done a really good job at allocating capital and they’re approaching a point where only intelligent investors own their stock and it’s pretty fairly valued. They’re going to start issuing a dividend next year, but a catastrophic event wipes them out. (Or, some other major change occurs for another industry, think newspapers —> digital distribution shift)

    Yes, they reinvested all that cash very successfully, and they also bought back stock at the right times. But unless you sold some stock to the company in those buybacks, you would wind up with a big 0.

    I’m torn on how to approach this. Yes, the _intrinsic value_ is 1 thing, but would issuing a dividend be more conservative? A share repurchase does put cash in the hands of shareholders, but not all, only some – probably the ones selling at a price lower than intrinsic value. What happens to the person who buys it and holds it for a lifetime?

    I think Buffett’s approach of looking for a long runway makes sense for this reason – too much change, and the investments just won’t work out. I think many tech companies aren’t really companies at all – they’re just “projects.” They should be issuing not stock, but just convertible bonds, or something of the sort. I’m a total outsider, but I think many don’t turn out to be businesses like they thought, even if they generate profit for a while.

    One company that comes to mind is Research in Motion. I’m sure they “reinvested” in a ton of projects, but if the core business fails for whatever reason, then most of the shareholder value is wiped out. It’s almost like the value only exists on the way up, and on the way down, the “value” disappears. This might be why companies like Wal*Mart or Wrigley’s can work so well – the runway is pretty long. (Wal*Mart may face challenges from Amazon, I’m not sure)

    I used to consider myself good at valuing net-net’s, because I would go through and figure out what I thought it would cost on the way down to exit leases and all the things like that. In reality, most never saw a disposal of cash, and I just got lucky that some other fool bought it on the way down.

    I don’t know what the formal definition of a security is, but I think it’s just something that pays out money. Let’s say your bond yields 6% above 1-year LIBOR and it’s very safe, but no one ever refinances it, and so you end up saying “Okay, instead of dealing with the lawyer/court fees of a Chapter 11, just keep giving me my 6% above 1-year LIBOR _forever_.” That, in my opinion, is a security. Now… the day that the “par value” is wiped out, I lose my position. A business *might* be something that should stand indefinitely and the securities just represent the profit from it. The challenge with equities is very similar to bonds, but it can take a *lot* longer to know if we’re right or not – until the day the cash is released in the form of a dividend or dividend-equivalent (share repurchase in pro-rata form from all shareholders), we won’t truly know how we did. At least with bonds, you get an interest payment of some kind.

    Buffett describes equities as “100 year bonds” and I think he’s 100% right. They have a really long tail and we won’t know how we did for a really long time in most cases.

    Am I incorrect in my thinking? My goal is to get better at understanding what it would take for me to own something in private, forever. If I couldn’t ever get out of a position, the only value that I think it would hold is the amount of cash it releases. In Buffett’s case, this will mean that the value he created will be measured long after he dies.

  2. Hey Ankit, Your example is interesting, but is it really true to say that an insurance company that could be wiped up if a disaster happens would be better served conserving equity, not doing buybacks nor distributing dividends?

    So the company in your example didn’t really, IMO, use its capital correctly. A company should not reduce its equity if it makes it that much more likely to go bankrupt.

    • That’s a really good point. I think my example of a catastrophe might have not been the best.

      If we think about newspapers though – if we bought their stocks in the 80’s, we would have probably had 20-30 years of good performance until their revenues began to fall as advertising. Would it have been a worthwhile purchase if we could have never sold the stock at all?

      I look at RIMM and think about this too. Let’s just say that RIMM shut down overnight and liquidated and they wound up with $3.4B of cash. So in their entire existence, the actual realizable value of the company would end up being $3.4B, because they’ve never issued a dividend while being publicly traded. (They had a < $1 million dividend in 97 before the IPO)

      So if we were to discount that $3.4B, that's all that RIMM was ever worth to shareholders. Despite that, the valuations it traded at would have varied wildly during that entire time period. It's almost like the P/E multiples, EBITDA multiples, and so on, were really useless because any decent multiple would have yielded a value way too high, when the actual cash return was only $3.4B.

      I haven't done enough digging around to know all of these facts, but they are a part of what I've been thinking about lately. It almost leads me to wanting commodity businesses with a competitive advantage of others of some kind so that the odds of them being around in 50 years in pretty high. I don't want to have to make a guess on what the demand could look like or what new competitors could do, because it's not really all that profitable for the most part.

      • I found this post at Bronte Capital interesting. I think it’s relevant to your thoughts on commodity businesses.

        • Thank you Scott: I good article on capital allocation in a commodity (cyclical) business.

        • Thanks for posting this. I sometimes view commodities as things that anyone has access to. So car insurance for example – I like GEICO because they have a cost advantage that is durable. Competitors haven’t been able to really copy them in a large amount for the last 40 years, because it would interfere with their existing business and they would have to kill themselves (the bigger portion) in order to make this new, smaller portion, work. The advantage of going direct to the consumers is huge for insurance. So I see them as a commodity producer with a durable competitive advantage, which I know won’t last forever (100+ years), but it will have a long enough runway and then hopefully a culture of being cheap that it will continue to do well. I wish I could find more GEICO’s 🙂

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